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Ambit - Economy The Political Underpinnings of Inflation in India
Ambit - Economy The Political Underpinnings of Inflation in India
(YoY change, in %)
a hawkish RBI Governor has resulted in a widespread expectation of
CPI inflation
8%
more rate cuts. This view ignores the political underpinnings of inflation
in India, whereby a systematic step-up in inflation materialises in the 4%
run-up to General Elections. There appear to be two key drivers which
propel inflation higher, namely: (1) higher subsidy spends being 0%
undertaken in the last two years of a five-year cycle; and (2) the need
1984-89
1991-96
1999-04
2004-09
2009-14
for election funding, leading politicians to collude with promoters who
suppress competition, and then push through price hikes. We retain our
view that limited rate cuts to the tune of 0-25bps are likely to be First three years Last two years
administered in FY17. Furthermore, we highlight the risk of INR volatility
increasing and revex spends rising (either at the cost of public Source: CEIC, Ambit Capital research
investment or at the cost of fiscal discipline) in FY18-19.
Exhibit B: Subsidy payments tend to
Inflation is unlikely to be benign in FY18-19
be higher in the last two years of a
Between 4QF14 and 4QFY16, CPI inflation eased by 290bps, policy rates have five-year election cycle
been cut by 150bps, India’s CAD has been recorded at an average of 0.1% of
GDP and the INR too has been stable. All of this has led investors to perceive
3%
India as a haven of stability in a world where sliding EM currencies are a norm.
(as % of GDP)
cuts are being widely expected. This consensus view that inflation is under
control and more rate cuts are on the anvil ignores the political underpinning of
1%
inflation in India whereby a step-up in inflation typically materialises in the run-
up to General Elections (see exhibit in the right hand margin). Our discussions
with our sources in Delhi and in state capitals suggest that the historical pattern 0%
2004-2009
1984-89
1991-96
1999-04
2009-14
is likely to be repeated again.
The political underpinnings of the inflation cycle in India
A historical analysis of inflation cycles in India suggests that average inflation
tends to be higher in the last two years leading up to a General Election. There First three years Last two years
appear to be two key drivers which propel inflation higher in the run-up to
General Elections. Firstly, public finance data suggests that subsidy spends tends
Source: CEIC, Ambit Capital research
to be higher in the last two years in the run-up to a General Election (see exhibit
B on the right side). Secondly, the requirement for election funding becomes Exhibit C: The need for election
acute in the last two years leading to an election. Politicians raise the bulk of this funding drives inflation in India
funding requirement by colluding with a promoter, suppressing competition in
his/her sector and thereby allowing the incumbent corporate to push through
price hikes (see exhibit C on the right side).
Macroeconomic implications
Besides the political economy dynamics that are likely to drive inflation higher in
the run-up to the CY19 General Election, GST implementation will add to
inflation as well (according to the current Chief Economic Advisor, a GST rate of
+15.5% could add to inflation by 30-70bps). We hence retain our view that rate
cuts to the tune of only 0-25bps are likely to be administered in FY17.
There are two other macroeconomic implications of this development. Firstly, Source: Ambit Capital research
history suggests that the INR is prone to heightened volatility in the run-up to
the General Elections. If this were to happen in FY18 and FY19, i.e. the last two Research Analysts
years in the current General Election cycle, then this dynamic coupled with the
Ritika Mankar Mukherjee, CFA
fact that India’s KAS is diminishing quarter after quarter will put pressure on the
INR. Secondly, history also suggests that the Central Government’s spending on +91 22 3043 3175
the rural economy tends to rise in the run-up to a General election. If this ritika.mankar@ambit.co
dynamic were to play out in FY18 and FY19, then it will provide support to the Sumit Shekhar
rural consumer whilst resulting either in compromised public investment growth +91 22 3043 3229
or in fiscal indiscipline.
sumit.shekhar@ambit.co
Ambit Capital and / or its affiliates do and seek to do business including investment banking with companies covered in its research reports. As a result, investors should be aware that Ambit Capital
may have a conflict of interest that could affect the objectivity of this report. Investors should not consider this report as the only factor in making their investment decision.
Economy
“Inflation tends to increase immediately after elections, perhaps as a result of pre electoral expansionary
Political cycles in OECD countries, Harvard monetary and fiscal policies discouraging saving, raising the cost of capital and contributing to political
university, https://goo.gl/cPR98k) instability.”
8.6%
7.2% 7.7%
8%
5.0%
3.8% 4.0%
4%
0%
1984-89
1991-96
1999-04
2004-09
2009-14
First three years Last two years
Furthermore, excluding the two GE cycles when inflation was recorded at elevated
levels throughout the five-year cycle (i.e., recorded at +10%), the differential was
wider at 140bps.
Average food inflation was higher
An analysis of the constitution of CPI suggests that this differential is largely driven by
by 230bps in the last two years
higher food inflation. Average food inflation was higher by 230bps in the last two
leading up to a GE
years leading up to a GE in the case of the last 4 election cycles (see exhibit below).
Exhibit 3: In the case of the last 4 election cycles, average CPI food inflation was
higher by 230bps in the two years leading up to a General Election
16%
CPI IW food inflation
12.1%
10.9% 11.5%
(YoY change)
8%
5.2%
4% 3.2%
1.5%
0%
1991-96
1999-04
2004-09
2009-14
Source: CEIC, Ambit Capital research, Note: Data for the election cycle spanning 1984-89 has been excluded as
the data for the food component is not available for this period.
This trend of inflation being higher in the run-up to a General Election is reflected in Average WPI inflation was higher
the WPI gauge as well. Average WPI inflation was higher by 110bps in the last two by 110bps in the last two years
years leading to a GE in the case of the last 5 election cycles (see exhibit below). leading up to a GE
Exhibit 4: Average WPI inflation was higher by 100bps in the two years leading up to
a General Election in the case of the last 5 election cycles
12% 11.3%
10.7%
WPI inflation
(YoY change)
9.3%
7.8% 7.4%
8% 6.5%
5.6% 5.4%
4.7% 4.4%
4%
0%
1984-89
1991-96
1999-04
2004-09
2009-14
First three years Last two years
Under UPA-II, in fact average WPI inflation rose by 390bps in the run-up to the Inflation for agricultural labourers
General Election of 2014. on an average rises by 260bps in
the last two years of a General
A geographical analysis suggests that this trend is more profound in rural India as election cycle as compared to
compared to urban India. Inflation for agricultural labourers on an average rises by 60bps for industrial workers
260bps in the last two years of a General election cycle as compared to 60bps for
industrial workers (see exhibit below).
Exhibit 5: Inflation in rural areas rose by an average of Exhibit 6: Inflation in urban areas rose by an average of
260bps in the run-up to a General Election 60bps in the run-up to a General Election
16% 12%
10%10% 10% 10%
CPI Agri labourers
(YoY change, in %)
12% 11%
(YoY change, in %)
0% 0%
1984-89
1991-96
1999-04
2004-09
2009-14
1991-96
1999-04
2004-09
2009-14
First three years Last two years First three years Last two years
Source: CEIC, Ambit Capital research Source: CEIC, Ambit Capital research
Once again, excluding the two GE cycles when inflation was recorded at elevated
levels throughout the five year cycle (i.e. recorded at +10%), the average differential
was wider at 290bps for rural areas and 140bps for urban areas.
3%
2.4%
Central Govt. Subsidies
2.2%
1.9%
2% 1.6% 1.7% 1.6%
(as % of GDP)
1.5%
1.3% 1.3%
1.1%
1%
0%
2004-2009
1984-89
1991-96
1999-04
2009-14
This is likely to be motivated by the fact that politicians are keen to improve the real Politicians are keen to improve the
income of the electorate via higher subsidy support in the run-up to a GE. This in turn real income of the electorate via
stokes inflation as history points to the existence of positive correlation that exists higher subsidy support in the run-
between: (1) higher subsidy spends and wage inflation; and (2) wage inflation and up to a GE
food inflation (see exhibits below).
Exhibit 8: Higher subsidies result in higher wage Exhibit 9: … which in turn leads to higher food inflation
inflation…
WPi-food inflation
16%
2.5%
(YoY change)
14%
(as % of GDP)
2.0% 12%
10%
1.5%
8%
1.0% 6%
4%
0.5%
2%
0.0% 0%
-5% 0% 5% 10% 15% 20% 25% 0% 5% 10% 15% 20% 25%
Source: CEIC, Ambit Capital research. Note: (1) Data pertains to FY01-FY16; Source: CEIC, Ambit Capital research. Note: (1) Data pertains to FY06-FY16
(2) Wage data for FY16 is available until Feb 2015. because data for the period spanning FY01-FY05 is not available as per the
new series for WPI; (2) Wage data for FY16 is available until Feb 2015.
80%
(YoY change)
60%
WPI pulses
40%
20%
0%
-20%
Apr-05
Oct-05
Apr-06
Oct-06
Apr-07
Oct-07
Apr-08
Oct-08
Apr-09
Oct-09
Apr-10
Oct-10
Apr-11
Oct-11
Apr-12
Oct-12
Apr-13
Oct-13
Apr-14
Oct-14
Apr-15
Oct-15
Apr-16
As highlighted in our note dated December 17, 2015 “A tale of two crops” even
though there exists a severe excess demand situation with regards to pulses in India,
the Government support price structure is distorted in favour of cereals (owing to
political economy reasons since cereal farmers are far greater in number than pulses
formers, supporting the former makes political sense). Therefore, whenever subsidy-
support drives up real incomes, demand for pulses rises but farmers have little
incentive to shift away from cereals production, thereby resulting in high pulses price
inflation (see exhibit below).
20 58% 57%
17 56%
Number of states going
16 16
15
states up for election
16 14 56%
13 53%
for elections
54% 53%
12
52% 51%
8 50%
50%
4 48%
0 46%
1999-04 2004-09 2009-14 1999-04 2004-09 2009-14
First three years Last two years First three years Last two years
Source: Election Commission of India, Ambit Capital research Source: Election Commission of India, CEIC, Ambit Capital research
Politicians meet this acute need for election funding in the last two years before a GE Politicians meet this acute need for
by colluding with businessmen, suppressing competition in that sector and thereby election funding in the last two
allowing the crony capitalists to push through price hikes. years before a GE by colluding
with businessman, suppressing
Since the need for election funding tends to be most profound in the run-up to a
competition
General Election, this cycle comprising of suppression of competition, corruption and
resulting inflation could be responsible for driving inflation in the years leading to a
GE (see exhibit below).
Exhibit 15: How corruption drives inflation in India in the last two years ahead of a
General Election
Source: Ambit Capital research. For more details on how this cycle works, click here for our May 2014 thematic.
Macroeconomic implications
There are two macroeconomic implications of this phenomenon whereby inflation
tends to pick up in the run-up to an election.
Firstly, history also suggests that the INR is prone to heightened volatility in the run-
up to the General Elections (presumably since higher inflation rates are associated History suggests that the Central
with weaker currencies). If this dynamic were to play out in FY18 and FY19, i.e. the Government’s spending on the
last two years in the current General Election cycle, then this coupled with the fact rural economy also tends to rise in
that India’s KAS is diminishing quarter after quarter will put pressure on INR. the run-up to a General election
Secondly, history suggests that the Central Government’s spending on the rural
economy also tends to rise in the run-up to a General election (presumably to offset
the impact of higher inflation amongst the largest electoral constituency in India). If
this dynamic were to play out in FY18 and FY19, then it will provide support to the
rural consumer whilst resulting in compromised public investment growth or fiscal
discipline.
In light of these dynamics it appears unlikely to us that going forward a new RBI
Governor will be able to find space for meaningful interest rate cuts.
Implication#1: Increased volatility in the currency markets
History suggests that volatility in the INR tends to rise by 90bps on an average in the
last two years of an election cycle (see exhibit below).
Exhibit 16: The INR has been more volatile in the last two years of an election cycle
14%
Coefficient of variation for
11%
12%
10% 9.2%
INR/USD
8% 6.8% 6.7%
6% 5% 5.3%
4.6%
4% 3% 2.4%
2.2%
2%
0%
1984-89 1991-96 1999-04 2004-09 2009-14
If this dynamic were to play out in FY18 and FY19, i.e. the last two years in the India faces a potential US$25bn in
current General Election cycle, it will put further pressure on the INR. This situation is outflows when FCNR deposits
complicated by the fact that: (1) India faces a potential US$25bn in outflows when raised in 2013 mature
FCNR deposits raised in 2013 mature; and (2) India’s Capital Account Surplus (KAS)
has been diminishing quarter after quarter (see exhibit below).
8%
Capital account surplus/Net
6%
Balance od payments
4%
(as % of GDP)
2%
0%
-2%
-4%
1QFY12
2QFY12
3QFY12
4QFY12
1QFY13
2QFY13
3QFY13
4QFY13
1QFY14
2QFY14
3QFY14
4QFY14
1QFY15
2QFY15
3QFY15
4QFY15
1QFY16
2QFY16
3QFY16
4QFY16
Net BoP KAS
80% 75.1%
Allocatio Ministry of
50.1%
rural development
40% 19.5%
(YoY change)
13.4%
0.1%
0%
-2.6%
-40%
1999-04
2004-09
2009-14
The first two years of NDA Government saw revenue expenditure as a percentage of The first two years of NDA
GDP decline compared to the UPA years (see exhibit below). However, in its latest Government saw revenue
budget for FY17 the Government has marginally increased revenue spends and this expenditure as a percentage of
trend appears likely to entrench itself further as the Government is likely to work to GDP decline compared to the UPA
restrict the impact of higher inflation on the lower economic strata. years
Exhibit 19: The restrained growth of revex under the NDA-II in FY15 and FY16 is likely
to come under pressure
14%
13.0%
13%
12.4%
(as % of GDP)
13%
Revex
12% 11.7%
11.4% 11.5%
12%
11%
11%
UPA I UPA II FY15 FY16 FY17 (BE)